El-Erian: Keep a Close Eye on Italy

What happened in Italy last week was notable. If it continues, it would mark a significant extension of the regional debt crisis that Europe has repeatedly failed to come to grips with.

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Market measures of Italian sovereign riskspiked last week. On Friday alone, the credit spread on 5-year debt instruments widened by 30 basis points — an astonishing amount for a country of Italy's economic and financial standing.

For the week as a whole, the spread widened by some 70 basis points and set a new record. Meanwhile, the yield on the 10-year benchmark bond reached 5.28%, its highest level since 2002.

The damage was not limited to the sovereign. The stocks of Italian banks tumbled. Intesa lost 12 percent for the week, and Unicredit fell by 8 percent on Friday alone.

If such dislocations persist and worsen, Spain will find it harder to resist contagion. In such circumstances, broader questions will be raised about the integrity of the Euro-zone.

Understandably, Reuters quoted on Sunday a senior ECB official as saying "We can't go on for many more days like Friday. We're very worried about Italy."

They are not the only ones. As also reported in Sunday's Reuters article,an emergency meetingis being called in Brussels that will gather top European officials.

Market participants should keep a close eye on all this.

Compared to the three countries already in the European financial ICU (Greece, Ireland and Portugal), Italy is a significantly larger economy; and it plays a more important role in the Euro-zone.

Persistent market dislocations in Italy would mark a significant morphing of the European debt crisis. And it is not as if European officials are anywhere near getting their arms around the problem in Greece. Indeed, the insufficiently coherent policy response is one of the reasons why damage continues to spread throughout Europe.

The repeated failure to deal decisively with Greece's solvency problem has already contaminated the ECB's balance sheet; it raises doubts on the outlook for Ireland and Portugal; and it is now threatening Italy where messy domestic politics are not helping.

Fortunately, Italy is not Ireland and Portugal; and it is nowhere close to being Greece.

While the country's debt stock is high, the maturity profile is not as worrisome. Its investor base is less volatile. Adjustment fatigue is not an issue. The internal flexibility of the economy is greater. And the scope for corrective policy actions is much bigger.

Working closely with its European neighbors, Italy must urgently do its utmost to restore calm to its financial markets. But Italy will not succeed unless its efforts are accompanied by a more serious and decisive European approach to fixing Greece's twin problems of an overwhelming debt stock and an inability to grow.